DP6501 Monetary Policy, Default Risk and the Exchange Rate
|Author(s):||Bernardo Guimarães, Carlos Eduardo Soares Gonçalves|
|Publication Date:||September 2007|
|Keyword(s):||default, exchange rate, identification through heteroskedasticity, monetary policy|
|Programme Areas:||International Macroeconomics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=6501|
In a country with high probability of default, higher interest rates may render the currency less attractive if sovereign default is costly. This paper develops that intuition in a simple model and estimates the effect of changes in interest rates on the exchange rate in Brazil using data from the dates surrounding the monetary policy committee meetings and the methodology of identification through heteroskedasticity. Indeed, we find that unexpected increases in interest rates tend to lead the Brazilian currency to depreciate. It follows that granting more independence to a central bank that focus solely on inflation is not always a free-lunch.